Use of Exponential Smoothing Technique in Estimation of Returns in a Financial Portfolio (A Case of the Matatu Public Transport Business in Kenya)
Jumba Minyoso Sandra^{1}^{, *}, Joel Cheruiyot Chelule^{2}, Mungatu Joseph^{3}
Department of Statistics and Actuarial Studies, Jomo Kenyatta University of Agriculture and Technology, Nairobi, Kenya
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To cite this article:
Jumba Minyoso Sandra, Joel Cheruiyot Chelule, Mungatu Joseph. Use of Exponential Smoothing Technique in Estimation of Returns in a Financial Portfolio (A Case of the Matatu Public Transport Business in Kenya).American Journal of Theoretical and Applied Statistics.Vol.4, No. 6, 2015, pp. 484-495. doi: 10.11648/j.ajtas.20150406.19
Abstract: This study sought to develop consistent estimators for the conditional mean and conditional volatility using exponential smoothing technique and to use the estimators for the conditional mean and conditional volatility to estimate VaR and ES of a financial asset in a given financial portfolio. In particular, we take the Kenyan Matatu business as our financial portfolio and we estimate the ES of the daily returns obtained from Matatus travelling the Nairobi –Eldoret highway as provided by CLASSIC SACCO. In estimating the conditional mean and conditional volatility of the returns of our portfolio, the study explored the exponential smoothing technique, whereby exponentially decreasing weights were assigned to the returns. The study proved that the estimators for the conditional mean and conditional volatility are consistent and also that the estimators for the conditional mean and conditional volatility when conditional mean is known, are asymptotically normal. Further the study gives the estimators for the VaR and ES and proves that the VaR estimator is consistent.
Keywords: Expected Shortfall, Exponential Smoothing, Value At Risk, Conditional Mean, Conditional Volatility
1. Introduction
1.1. Background Information
In Kenya, when the demand for public transport began to outstrip its supply shortly after Independence in 1963, the government decided to tolerate and eventually regularize what had previously been informal commercial vehicles commonly known as Matatus (McCormick D. W., 2011). By the mid-2000s, it is estimated that half of Nairobi’s population relied on Matatus to meet their public transport needs(Dorothy McCormick, 2013)
This Matatu industry has a direct impact on over 500,000 people who are drivers, touts, or employees of PSV Sacco’s and stage attendants (MOA, 2014). As businesses, Matatus are privately owned; they do not enjoy government subsidies and are required to be registered and pay taxes.
In a legal notice issued on 23^{rd} December 2010, by the Ministry of transport, all the Matatus were to join SACCOs or limited liability companies by the end of the year 2010. By this time some of the SACCOs were effectively managing their routes, providing credit to their members for purchase of vehicles or repairs while one had established a fueling station for its members’ vehicles (Kibua1, 2004) with Classic Sacco being one of them. Classic Sacco manages over 170 Matatus plying the Nairobi-Eldoret route. Nairobi being the capital city of Kenya is approximately 164 miles away from Eldoret making this an approximately 5 hour drive distance when using public transport.
Returns from the Matatu business are a complete and scale-free summary of the investment opportunity in the industry
Increase of financial risks in financial portfolios the Kenyan Matatu industry; for example, have underlined the need for better financial risk measures.Matatu business owners deal with the risks associated with changes in prices that can be summarized by the variances of future returns, directly, or by their relationship with relevant covariance in a portfolio context. Forecasts of future standard deviations can provide up-to-date indications of risk, which might be used to avoid unacceptable risks (Aas & Dimakos, 2004). The nature of financial risks in different portfolios keeps on changing with time and therefore the methods to measure them should adapt accordingly. Furthermore, these methods should be easy to understand even in complex situations. It is in this context that quantitative risk measures have become vital in the management of risks. This study is therefore motivated by the need to know how to estimate market risks in the Matatu Industry market.
There are many types of risks i.e. market risks, credit risks and operational risks. In this study, we are focused on one type, the market risks. Market risks are risks that arise from the changes in the prices of financial assets and liabilities (or volatilities) and measured by changes in the value of open positions or in earnings.The market risks will be quantified using a statistical tool called ES. But we cannot avoid mentioning VaR when dealing with ES, since VaR precedes ES, by definition and computation.
1.2. Statement of the Problem
Matatus account for 80% of the total public transport in the country (Muriungi, 2013).The Matatu business can yield good returns for an investor if well managed. However the Matatu business experiences many challenges. The main challenge is keeping track of these returns so as to run a profitable business. In most cases, this happens due to poor monitoring of exposure to market risks by the management. It has been difficult to manage these market risks in the absence of accurate details available from regulatory authorities and related institutions. We intend to address this challenge by estimating ES of the returns as provided by the managing body Classic SACCO.
2.Literature Review
2.1. Volatility and Value at Risk
The main characteristic of any financial asset is its return. Return is typically considered to be a random variable. Its primary usage is to estimate the value of market risk. Volatility is also a key parameter for pricing financial derivatives. All modern option-pricing techniques rely on a volatility parameter for price evaluation (Ladokhin, 2009). Volatility is also used for risk management applications and in general portfolio management.
Volatility concept and its usage in financial risk management refer to the spread of all outcomes of an uncertain variable. In finance, we are interested in the outcomes of assets returns (Dr. Erik Winands, 2009). Volatility is associated with the sample standard deviation of returns over some period of time. Volatility is a quantified measure of market risk. Volatility is related to risk, but it is not exactly the same. Risk is the uncertainty of a negative outcome of some event (e.g. stock returns) while volatility measures a spread of outcomes (Tes´arov´a & Gapko, 2012). This includes positive as well as negative outcomes.
Volatility can be used in some risk management applications, such as Value at Risk (VaR). Accurate estimates of volatility are important for option pricing, portfolio analysis and risk management methodologies, such as value at risk (Madhavan & Yang, 2003). The observation that many financial series exhibit volatility clustering has led to the development of a great many time series methods for volatility forecasting
As a risk measure, volatility is an important concept in finance and plays a critical role in a wide range of applications such as asset pricing, portfolio management, risk management, and option valuation. (Tian, 2008). Volatility modeling is required for VaR estimation.
The main characteristic of any financial asset is its return. Return is typically considered to be a random variable. Its primary usage is to estimate the value of market risk
Value at risk (VaR) is commonly used in the financial industry to quantify risk in asset portfolios. Value-at-risk (VaR) has become a standard measure used in financial risk management due to its conceptual simplicity, computational facility, and ready applicability (Yoshiba, 2002). Many authors suggest that VaR has several conceptual problems (Artzner P. F., 1997) for example,
• VaR measures only percentiles of profit-loss distributions, and thus disregards any loss beyond the VaR level ("tail risk"),
• VaR is not coherent since it is not sub-additive.
2.2. Expected Shortfall
Expected shortfall is defined as the conditional expectation of loss given that the loss is beyond the VaR level. ES can be used to alleviate the problems present in VaR (Yoshiba, 2002) since expected shortfall considers the loss beyond the VaR level and has been proven to be sub-additive which assures its coherence as a risk measure. Expected shortfall has less of a problem in disregarding the fat tails and the tail dependence than VaR does. VaR is not a risk measure because it does not fulfill the axiom of sub—additivity (Tasche, 2001)
2.3. Past Reviews on Exponential Smoothing
The two most popular time series approaches are GARCH models and smoothing methods. In contrast to the statistical rigor of GARCH models, smoothing methods provide a pragmatic, ad hoc approach to volatility forecasting (Taylor, 2008) Exponential smoothing is a popular approach, which has been found to perform well in empirical studies. (Boudoukh, 1997) It involves the allocation of exponentially decreasing weights to past squared shocks. Another common application of exponential smoothing is inventory control, where it is used to predict the level of a time series of demand.
An advantage of exponential smoothing is that it uses declining weights which "captures the cyclical behavior of return volatility." Exponential smoothing’s simple and popular approach to volatility forecasting is to estimate the variance as a simple moving average of past squared shocks. (Boudoukh, 1997) writes that this estimator has two clear weaknesses. Firstly, if volatility clusters, there is strong appeal to giving more recent information greater weighting, and, secondly, the choice of how many past periods to include in the moving average is arbitrary. Exponential smoothing is also widely used to produce forecasts for the level of a time series (Gardner, 1985). An alternative is to use GARCH the down-side of which is that it adds (some) complexity. Exponential smoothing may be a good compromise between quality and complexity for Value at Risk. (pat, 2013)
The exponential estimator is asymptotically fully adaptive to unknown conditional mean functions when its asymptotic properties are established and compared with those for the local linear estimator and the exponential estimator also shows superior performance when it is applied to estimate conditional volatility functions, ensuring its non-negativity (Su. et al, 2002).(Huy-Nhiem Nguyen, 2010) shows that the noisy nature of realized volatility may benefit from smoothing techniques
At the same time Exponential smoothing and exponentially weighted moving average give one of the best results among all volatility forecasting models. These two models have the lowest RMSE using the testing set. (Ladokhin, 2009)
2.4. Concepts and Definitions
We consider the problem of forecasting a value each period, which will be exceeded with probability by the current portfolio, where is a specified confidence level associated to the Value at Risk (VaR). Let be real-valued and represent information available at time . We will assume that is measurable. Let the sequence of random variables taking the values in R be stationary. Here, can be considered as the response variable and (the past information of are the predictor variables (or covariates). Specifically, we want to estimate the conditional mean and the conditional volatility of , given the past information,, with the assumption that the function is completely determined by , for . So, we have our underlying process of interest of the form as in Mwita (2003).
(2.1)
Where
1) is the conditional mean function of given the past information,,
2) is the conditional volatility function of given the past information,,
3) and are the standard error terms, which we assume to be independent of and normally distributed with mean 0 and variance 1.
The conditional quantile of (2.1) given is then given by
or simply
where is the quantile of and .Suppose are independent and identically distributed (i.i.d) standard normal random variables, then
Definition (Risk)
Risk is the dispersion (volatility) of unexpected outcomes, generally the value of assets or liability of interest. Alternatively, we can also define risk as the quantifiable likelihood of loss or less-than-expected returns.
Definition (Risk measure)
Consider a set Q of real-valued random variables. A function is called a risk measure if it is
(i) monotonous:
,
(ii) sub-additive:
(iii) positivelyhomogeneous:
and
(iv) translation invariant:
Definition (Value at Risk)
The Value at Risk, , based on negative returns or losses at time t given the past information of is defined by,
is the conditional -quantile of given .In essence, we find such that
(2.2)
is the probability of extreme losses greater than the usually taking the values 5% or 1% corresponding to one or ten day(s) periods respectively.
Definition (Expected Shortfall)
Supposeis a random variable denoting the negative returns of a given portfolio on a specified time horizon and is the VaR at the percent confidence level. The Expected Shortfall is defined by the following equation:
(2.3)
2.5. Exponential Smoothing (ES)
Exponential smoothing is a popular scheme used to produce a smoothed time series. This forecasting procedure was first suggested by C. C Holt in about 1958. By definition, Exponential Smoothing is simply an adjustment technique, which takes the previous period’s forecast and adjusts it up or down based on what actually occurred in that period. It accomplishes this by calculating a weighted average of the two values. The formula takes the form:
Where is the yesterday’s actual value; is the forecasted value; is the weighing factor or Smoothing constant and t is the current time period.
Whereas in single moving averages, the past observations are weighted equally, exponential smoothing scheme weight past observations using exponentially decreasing weights to forecast future values. In other words, recent observations are given relatively more weight than the older observations.
2.5.1. Single Exponential Smoothing
This smoothing scheme begins by setting to , where stands for smoothed observations or exponentially weighted moving average (EWMA), and X stands for the original observation. The subscripts refer to the time periods .For, the smoothed value is found by computing
(2.4)
There is no . The smoothed series starts with the smoothed version of the second observation. Equation (2.4) is the basic equation of Exponential Smoothing and the constant or parameter is called the smoothing constant.The first forecast is very important, and the smaller the value of the , the more important is the selection of the initial exponentially weighted moving average. The initial smoothed observation plays an important role in computing all the subsequent EWMA’s.
The following are some of the methods of initialization: Setting to ; Setting to the target of the process; Setting to the average of the first four or five observations.
2.5.2. Double Exponential Smoothing
Double exponential smoothing uses two constants and is better at handling trends. Single exponential smoothing does not excel in following the data when there is a trend. This situation can be improved by the introduction of a second equation with a second constant, , which must be chosen in conjunction with .The following are the two equations associated with double exponential smoothing:
(2.5)
(2.6)
Here, we note that the current value of the series is used to calculate its smoothed value replacement in double exponential smoothing. There are several methods to choose the initial values for and . is in general set to while the following are three suggestions for :
; AND/OR
Smoothing equation (2.5) adjusts directly for trend of the previous period, , by adding it to the last smoothed, . This helps to eliminate the lag and brings to the appropriate base of the current value.The second smoothing equation (2.6) then updates the trend, which is expressed as the difference between the last two values. The equation is similar to the basic form of single exponential smoothing but here applied to the updating of the trend.
Why exponential smoothing?
Exponential smoothing relies on only two pieces of data (the last period’s actual value and the forecasted value for the same period). Therefore, it minimizes the data storage requirements. If we use the moving averages method to forecast, we need to have M past values. This is cumbersome if there are many items for which forecasting is required. Exponential smoothing technique is very simple in concept and easy to understand and is often used on large-scale statistical forecasting problems because it is both robust and easy to apply.
3. Estimators for the Conditional Mean and Conditional Volatility
3.1. Estimator for the Conditional Mean
Refer to model (2.1). We want to estimate the conditional mean, , given past information, . In improving the normal method of estimating, i.e., , where is the sample size and are the observations, we introduced horizons as the time we look back to estimate the conditional mean of the returns for the day. So as to achieve better estimate of , the horizon should be large enough. In our case, we chose to use a horizon of 250 days.We also thought about the influence of the past on the today’s mean and noted that the behavior of the matatu returns several days ago should not influence the as much as yesterday’s behavior. So we weighted the returns with weights, . These weights should decrease exponentially as the returns get older. That is, recent returns are given relatively more weight than older returns. Therefore, the weights are given by
for some (3.1)
where is the weighting factor or smoothing constant.It is expected that these weights should sum up to 1, but because we cannot look back an infinite time span, the sum of the may not sum up exactly to 1. But for horizons,, large enough, the sum is approximately equal to 1. For example, suppose we look at a horizon of 250 days (as in our case) and a of 0.95, the ’s sum up to 0.99997.We now define our estimator for the conditional mean. Let
be a sequence of returns, where is the size of the horizon we take at time and is the sample size large enough such that we can have a number of horizons that can give a vector of estimates for the conditional mean. The estimator for the conditional mean is given by
(3.2)
Where , is the smoothing constant; t is the current time period; is the time horizon.
Definition (Point estimator)
If we have a random sample from a density, say , which is known except for , then a point estimator of is a statistic, say , whose value is used as an estimate of .
Definition (Convergence)
A sequence of random variables are said to converge in probability to a constant if for every ;
or alternatively,
Convergence in probability is denoted by
Definition (Weak Consistency)
Let be a sequence of point estimators of , where . The sequence is defined to be a weakly consistent sequence of point estimators of if the following conditions are satisfied:
;
Assumptions
(A1)
(A2)
(A3) where represents an observation in one horizon e.g and represents an observation in another horizon e.g
.Some remarks on the assumptions are in order. Assumption (A2) is made to guarantee that all variables in the model have a finite variance and assumption (A3) shows that correlation between observations diminishes to zero as the distance between and becomes large.
Theorem 3.1(Consistency for the conditional mean estimator)
Let be a random sample of returns with mean and variance .Then,
is a weak consistent estimator of .
Proof of theorem 3.1
We show that and
. We proceed as follows:
(3.3)
(3.4)
(3.5)
(3.6)
(3.7)
(3.8)
(3.9)
(3.10)
(3.11)
which implies that .
Remarks
a) Equation (3.4) is obtained from equation (3.3) by noting that . That is, the time horizon we have selected is large. Therefore, by the central limit theorem, the returns are normally distributed with mean and variance i.e. . Hence, we have and . In a similar way, equation (3.9) is obtained from equation (3.8), under assumption (A3).
b) Equation (3.5) is obtained by summing equation (3.4) over the horizon, . Similarly, equation (3.10) is obtained from equation (3.9).
c) Equations (3.6) and (3.11) are obtained by noting that .
d) Equation (3.7) is obtained from equation (3.6) by noting that the weights sum up to 1 as .
Definition (Asymptotic normality, see Alexander et al (1974))
A sequence of estimators of is defined to be best asymptotically normal (BAN) if and only if the following four conditions are satisfied:
(i) The distribution of approaches the normal distribution with mean 0 and variance as n approaches infinity.
(ii) For every ,
(iii) Let be any other sequence of simple consistent estimators for which the distribution of approaches the normal distribution with mean 0 and variance .
(iv) is not less than for all in any open interval.
Lemma 3.1 (George, G. (1973))
Let {} be a sequence of density functions, and let be a density function. Let be the characteristic function corresponding to and be the characteristic function corresponding to. Then,
(i) If for all continuity points of , then, for every .
(ii) If converges, as , and , to a function which is continuous at , then g is a characteristic function, and if is the corresponding density function, then
for all continuity points of .
Lemma 3.2 (George, G. (1973))
Let and be density functions such that , , and let be continuous. Then the convergence is uniform in .
Theorem 3.2 (Asymptotic normality for the conditional mean estimator)
Assume (A1), (A2), (A3) hold. Then, is asymptotically normal with mean 0 and variance
.That is,
as , where
]
Proof of theorem 3.2
We apply the central limit theorem. Let
and . Then, we show that
uniformly in . But before we proceed to the proof proper, it is in order that we make the following comments as in George, G. (1973):
(i) Let , be two sequences of numbers. We say that is and we write , if. For example, if
and , then , since . Clearly, if , then
. Therefore, , .
(ii) If , then .
We now begin the proof. Let be the characteristic function of and be the characteristic function of ; that is, ,
By lemma 3.1, it suffices to proof that . This will imply that . Then, by lemma 3.2, the convergence will be uniform. We have
where with . Hence, for simplicity, writing instead of , when this last expression appears as a subscript, we have
Now consider the Taylor expansion of around zero up to the second order term. Then
Since
we get
Thus
Taking limits as we have, , which is the characteristic function of . Hence, the prove.
3.2. Estimator for the Conditional Volatility
Refer to model (2.1).We want to estimate the conditional volatility, , of , given past information, . As we did in section (3.1), we introduced the horizons . Again, we also thought about the influence of the past on the today’s mean and noted that the behavior of the matatu returns several days ago should not influence the as much as yesterday’s behavior. So we weighted the returns with the same weights, , as in equation (3.1).
We now define our estimator for the conditional volatility. Let be a sequence of returns defined as in section (3.1). We define the estimator for conditional volatility under the following situations:
1. When the conditional mean,, is known, the estimator is given by
(3.12)
2. When the conditional mean,, is unknown, the estimator is given by
(3.13)
Where in both cases, , and are as defined in section (3.1).
The justification for squaring the returns,, is as follows:Refer to our model (2.1), that is, . Assuming , we have . Thus,
. Taking conditional expectation, we have E(. .
Theorem 3.3 (Consistency for when is known)
Let be a sequence of returns with mean and variance,
.
Then,
is a simple consistent estimator for .
Proof of theorem 3.3
We show that and
We proceed as follows:
E(
=
=
(3.19)
which implies that
Remarks
a) Equation (3.15) is obtained from equation (3.14) by noting that . That is, the time horizon we have selected is large. Therefore, by the central limit theorem, the returns are normally distributed with mean and variance i.e. . Hence, we have and . In a similar way, equation (3.20) is obtained from equation (3.19), under assumption (A3).
b) Equation (3.16) is obtained by summing equation (3.15) over the horizon, . Similarly, equation (3.21) is obtained from equation (3.20).
c) Equations (3.17) and (3.22) are obtained by noting that .
d) Equation (3.18) is obtained from equation (3.17) by noting that the weights sum up to 1 as .
Theorem 3.4 (Asymptotic normality for when is known)
Assume (A1), (A2), (A3) hold. Then, is asymptotically normal with mean 0 and variance
.That is,
as , where
.
Proof of theorem 3.4
We apply the central limit theorem. Let
And . Then, we show that
uniformly in . But before we proceed to the proof proper, it is in order that we make the following comments as in prove of theorem (3.2):
I. Let , be two sequences of numbers. We say that is and we write , if. For example, if
and , then , since . Clearly, if , then
. Therefore, , .
II. If , then .
We now begin the proof. Let be the characteristic function of and be the characteristic function of ; that is, ,
By lemma 3.1, it suffices to proof that . This will imply that . Then, by lemma 3.2, the convergence will be uniform. We have
where with . Hence, for simplicity, writing instead of , when this last expression appears as a subscript, we have
Now consider the Taylor expansion of around zero up to the second order term. Then
Since
we get
Thus
Taking limits as we have, , which is the characteristic function of . Hence, the prove.
Theorem 3.5 (Consistency for when is unknown)
Let be a random sample of returns with mean and variance,
Then,
is a simple consistent estimator for .
Proof of theorem 3.5
We show that and
We proceed as follows:
has a Chi-square distribution with degrees of freedom. Therefore,
and
Hence,
(3.23)
which implies that and so is . Hence, the proof.
3.3. The Smoothing Constant
The choice of the smoothing parameter is very important. However, although the theory of selecting this parameter is widely expanding, there is yet no one particular method that is universally acceptable as the standard. In any case, the basic principle underlying the choice of a smoothing parameter, is that the chosen value should result in the minimum mean square error.
Definition (Mean-Squared Error (MSE))
Let be an estimator of .
is defined to be the mean-squared error of the estimator .
3.4. Estimators for Value at Risk and Expected Shortfall
3.4.1. Estimator for Value at Risk (VaR)
The Value-at-Risk summarizes the expected maximum loss (or worst loss) over a target horizon at a given confidence level.In our case, we use a target horizon of 250 days and a 99% confidence level. . That means the Value-at-Risk we give is the amount of money we will at maximum lose the next day with probability of 99%.Or in other words, the probability to lose at the next day more than the calculated Value-at-Risk is less than 1%.
We obtain today’s returns,, as where and are today’s and yesterday’s returns respectively.. The conditional -quantile function for our econometric model (2.1) is given by
While the estimator for the conditional -quantile is given by
where and are as defined in equations (3.2) and (3.13) respectively.
Consistency for the estimator for Value at Risk
We show that and . We proceed as follows:
First, we check the bias
(4.6)
Next, we check the asymptotic variance.
(4.7)
(4.8)
(4.9)
(4.10)
Hence, the proof.
Remarks
a) Equation (4.4) is obtained from equation (4.13) by using assumption (A3) and noting that
and .
b) Equation (4.5) is obtained from equation (4.4) by noting that the weights sum up to 1 as .
c) In equation (4.9), and are obtained as in equations (3.11) and (3.24) respectively.
3.4.2. Estimator for the Expected Shortfall
Expected shortfall is the conditional expectation of loss given that the loss is beyond the VaR level, and measures how much one can lose on average in the states beyond the VaR level.
Suppose is a random variable denoting the negative returns of a given portfolio and is the VaR at the - confidence level. The Expected Shortfall is given by
The function for expected shortfall based on our econometric model (2.1) is given by
and the estimator for the expected shortfall is given by
where and are as defined in equations (3.2) and (3.13) respectively. is the number of negative returns that exceed and is an indicator function defined as
4. Results and Discussion
Here, we present analysis of average returns from Matatu business from May 2010 to August 2014. The results are given in the figures below.
In figure 1, the upper (positive) sides are the negative returns (losses) while the lower (negative) sides are the positive returns (profits). This is because we have used the negative log returns. We observe that the returns tend to cluster as the threshold increases. This suggests that the returns are auto correlated. The clustered returns over time represent clustering of volatilities. This is supported by Engle and Manganelli (2002) who noted that the distribution of returns tend to be auto correlated. The long spikes on either side indicate extreme returns.
In figure 2, we can observe that the conditional mean tend to be stationary for a long period of time as it keeps on reverting to the long term value, that is, 0. There are also some few positive and negative "outliers" or extreme means that seem not be consistent with the rest of the means. The negative "outliers" suggests that the market conditions were very favorable and the positive outliers suggest that the market conditions were very unfavorable.
In figure 3, it is evident that volatility varies with time. We can also observe that large volatilities tend to be followed by large volatilities. Similarly, small volatilities tend to be followed by small volatilities. We can also see that there was a shock as indicated by the extremely large volatilities that lasted for a short period (around day 500 to 550). A shock indicates either extreme gain or extreme loss in the market, depending on the conditions.
Figure 4. Matatu returns plotted together with .
Figure 5. Plot of MATATU returns with and Expected Shortfall.
In figure 4, we have superimposed 0.99-conditional quantile on the returns. VaR is always based on negative returns hence the plot of on the upper side. From the definition of VaR, 0.99-conditional quantile means that there is one chance in a hundred chances, under normal market conditions, for a loss greater than the VaR set by a given portfolio’s management, to occur in a given day. Therefore, the 0.99-conditional quantile measures the maximum loss a portfolio can incur at 99% confidence level. It is clear from figure 4 that the 0.99-conditional quantile responds well to the distribution of the returns. We can also see from the figure that there are some few returns that exceed the VaR.
In figure 5, we have superimposed the and expected shortfall over the on the returns. The straight line represents the expected shortfall. We can observe from the figure that the straight line representing the expected shortfall is slightly above the line representing the . Therefore, it is clear from the figure that VaR tells us the most we can expect to lose if a tail event does not occur while the expected shortfall tells us what we can expect to lose if a tail event does occur.
In our study, we have analyzed 963 MATATU returns. As per the definition of VaR at 99% confidence level, we expect, under normal market conditions, about 10 returns to exceed the . In our results, we have obtained 9 exceedences and expected shortfall of 0.1688. Therefore, our risk measuring method is good.
5. Conclusion
In estimating the conditional mean and conditional volatility of the returns of our portfolio, we explored the exponential smoothing technique, whereby we assigned exponentially decreasing weights to the returns. We noted that exponential smoothing technique is easy to understand and apply. We proved that the estimators for the conditional mean and conditional volatility are consistent. We also proved that the estimators for the conditional mean and conditional volatility when conditional mean is known, are asymptotically normal. Further, we have given the estimators for the VaR and ES and proved that the VaR estimator is consistent.
Recommendations
Exponential smoothing techniques has a few demerits including that it lags i.e. the forecast will be behind as the trend increases over time and it also may fail to account for the dynamic changes at work in the real world, and the forecast may constantly require updating to respond to new information.
In this respect, we note that exponential smoothing technique may not be the best estimation technique and that other techniques, GARCH estimation may be explored.
We also suggest that the following work may be done in future as a continuation of this research:
a) The choice of the optimal smoothing parameter. In our case, we have just fixed its value.
b) The proof of the asymptotic normality for the conditional volatility estimator when the conditional mean is unknown. Also, the asymptotic normality for the VaR estimator should be shown.
References